THE COST OF PRODUCTION

The firm's primary objective in producing output is to maximize profits. The

production of output, however, involves certain costs that reduce the profits a firm
can make. The relationship between costs and profits is therefore critical to the
firm's determination of how much output to produce.
I. COSTS
Explicit and implicit costs. A firm's explicit costs comprise all explicit payments to
the factors of production the firm uses. Wages paid to workers, payments to
suppliers of raw materials, and fees paid to bankers and lawyers are all included
among the firm's explicit costs.
A firm's implicit costs consist of the opportunity costs of using the firm's own
resources without receiving any explicit compensation for those resources. For
example, a firm that uses its own building for production purposes forgoes the
income that it might receive from renting the building out. As another example,
consider the owner of a firm who works along with his employees but does not draw
a salary; the owner forgoes the opportunity to earn a wage working for someone
else. These implicit costs are not regarded as costs in an accounting sense, but they
are a part of the firm's costs of doing business, nonetheless. When economists
discuss costs, they have in mind both explicit and implicit costs.
II. PROFITS
Accounting profits, economic profits, and normal profits. The difference between
explicit and implicit costs is crucial to understanding the difference between
accounting profits and economic profits. Accounting profits are the firm's total
revenues from sales of its output, minus the firm's explicit costs. Economic profits
are total revenues minus explicit and implicit costs. Alternatively stated, economic
profits are accounting profits minus implicit costs. Thus, the difference between
economic profits and accounting profits is that economic profits include the firm's
implicit costs and accounting profits do not.
A firm is said to make normal profits when its economic profits are zero. The fact
that economic profits are zero implies that the firm's reserves are enough to cover
the firm's explicit costs and all of its implicit costs, such as the rent that could be
earned on the firm's building or the salary the owner of the firm could earn
elsewhere. These implicit costs add up to the profits the firm would normally receive
if it were properly compensated for the use of its own resourceshence the name,
normal profits.
II. PRODUCTION FUNCTION

The production function describes a boundary or frontier representing the limit of

output obtainable from each feasible combination of inputs. Firms use the
production function to determine how much output they should produce given the
price of a good, and what combination of inputs they should use to produce given
the price of capital and labor.
The production function also gives information about increasing or decreasing
returns to scale and the marginal products of labor and capital.
Source: Boundless. Defining the Production Function. Boundless Economics
Boundless,
08
Aug.
2016.
Retrieved
17
Jan.
2017
from
https://www.boundless.com/economics/textbooks/boundless-economicstextbook/production-9/the-production-function-63/defining-the-production-function237-12335/
http://economicsonline.co.uk/Business_economics/Costs.html